This is the most advanced topic I have written for my public readers. But it can be an important topic, so hang in there.
According to conventional wisdom you should always name your spouse as beneficiary of an IRA. But if you are at all interested in asset protection that may not be a great idea. Read on to understand why it might be a better idea to name a trust as the beneficiary of an IRA and what some of the trade-offs of doing so are.
I’ll give you some specific examples (with numbers). That’s good if you are interested in learning about this . . . but then you shouldn’t attempt to read this if you are under the influence of anything!
Standing on Tradition: Naming The Spouse As IRA Beneficiary
There really is a good reason for naming the spouse as IRA beneficiary . . . much of the time. But not always.
As I have written, the beauty of an IRA is that the longer money can be allowed to languish in an IRA, the more it will grow without being burdened by taxes. Because of that, the usual thinking is to try and take out as little as possible.
On the other hand, there are all sorts of tax rules about when someone MUST take distributions and how much those distributions must be. Remember the rule:
SOMEDAY, SOMEHOW, SOMEONE WILL PAY TAXES ON THE IRA.
Meet the Finkmeisters
For purpose of illustrating some concepts, let’s look at Alfred and Betty Finkmeister.
Alfred is 81 and Betty is 75. Alfred owns a $100,000 traditional (not Roth) IRA. He has taken his required distribution for the year.
They have one child, Chelsea, who is 50.
Why Naming A Spouse As The IRA Beneficiary Is So Slick (Usually)
If a spouse “inherits” an IRA, she can treat it as her own. This means she does not have to begin distributions until she is 70 ½. When she does begin taking distributions she can use a special table that assumes she has a husband 10 years younger (heh, heh, heh) even though she may have just become a widow. That means MUCH smaller mandatory distributions because they are being spread out over her life and the life of Mister-Make-Believe-Ten-Years-Younger-Romeo. The spouse can also go back to the tables each year and get a new factor to divide by (it doesn’t go down by “1” each year . . . which stretches out payments even more).
The special spousal rules for inherited IRAs also say that she can name the kids as beneficiaries and upon her death they will have separate IRAs they can take out over their life expectancies (although I have found – quite nonscientifically – that most IRAs inherited by adult children quickly become new cars or tuition payments!).
Alfred dies at age 81. We will not look at special rules that pertain to what they must do for the year of his death. We’ll look to what Betty will need to do the year after his death.
He named Betty as the beneficiary. Betty can treat the IRA as her IRA for all purposes (only surviving spouses can do that).
The next year she will be 76 and will be required to take 1/22nd of the IRA as a minimum distribution (the correct chart says Betty has a 22 year life expectancy). The next year the factor will be 21.2, the year after that 20.3, and so on. Note that it doesn’t go down by a whole number “1” each year). The initial year Betty will be required to take a $4,545.45 distribution.
Later, Betty dies with $85,000 remaining in the IRA. Chelsea, now 53, is the sole beneficiary and may elect to take the IRA over her life (or to take the immediate tax hit and to use it as a down payment on a Maserati). If she takes life distributions, her first installment will be 1/43.6th or $1,949.54. However, because Chelsea is not a surviving spouse (like Betty was) the next year her factor will be 42.6, the following year 41.6, and so on. The factor is reduced by “1” each year, which results in a bit faster payout.
On The Other Hand . . .
Sometimes naming a spouse as IRA beneficiary is a bad idea. There may be reasons that outweigh the usual good tax reasons for naming a spouse. For example, I often encounter couples concerned about protecting assets for a surviving spouse in case he or she ever needs to go into a nursing home. An IRA left directly to a spouse will be a countable asset for Medicaid purposes. There may be other good asset protection motives involved, as well.
In the example above, if Betty went into a nursing home the IRA would be entirely countable for Medicaid purposes.
The solution may be to name a trust as the beneficiary of the IRA. That way, IRA assets may be protected while remaining available to benefit the surviving spouse.
There are a number of ways a trust can be designed, depending upon what the client and I are trying to accomplish. Much of how a trust will be treated depends upon whether it is something the IRS calls a “designated beneficiary.”
Is A Trust A Designated Beneficiary?
If Real Live People and Certain Trusts Benefit
If a trust benefits only real live (as in “beating hearts living”) people then the trust will be a “designated beneficiary.” If a trust says “Betty is the primary beneficiary and must receive all required IRA distributions, then upon her death to distribute whatever is left to Chelsea” . . . that will suffice. Of course, if Betty is in a nursing home, everything distributed will go straight to the nursing home. But in this case, the trust would receive an IRA distribution of $4,545.45 and pay it directly out to Betty (based on her age of 76 and a factor of 22.0). Later years would be calculated the same as under Example # 1, above.
If the trust says “Betty may receive all, some, or none of the IRA benefits, then when Betty dies Chelsea may continue to receive distributions.” In this case, the IRA must distribute to the trust $4,545.45 (which if Betty is age 76 is based on a factor of 22.0). But in later years the factor goes down by “1” for each year. The advantage is, the trustee doesn’t have to distribute to Betty a dime, which comes in handy if asset protection is important. The trade-off is that under this scenario the distributions come out of the IRA a bit faster and if they aren’t distributed to Betty they’re taxed inside the trustee at a steeper tax rate.
Compare this to what happens if Betty inherited the IRA directly: The distributions from the IRA come out a bit faster to the trust than if they had come directly to her. Further, once the timing is set-up, the distributions keep coming out to Chelsea at the same rate as if her mother was still alive. Of course, the trust could be drafted simply to give Chelsea all the cash upon Betty’s death and let Chelsea pony up the tax!
You’ll need to ask: “Is asset protection more important than tax efficiency?”
If “Non-people” and Certain Other Trusts Benefit
If the trust says “Betty may receive some, but not necessarily all benefits, then when Betty dies the North Carolina Zoo takes” the trust will not be a designated beneficiary. If a trust is NOT a “designated beneficiary” of an IRA, then the IRA must be distributed to the trust within five years if the owner dies before 70 ½ (you can wait until 4 years and 11 months if you want). If an IRA is not huge, being forced to completely distribute it within five years is not necessarily bad.
If the owner dies after age 70 ½ (which Alfred did) then the trust can take distributions over what would have been the deceased owner’s life expectancy had he been alive each year. That actually will be a bit faster than if he had been alive and married because the rules use different tables that calculate distributions as if the deceased owner were still alive and single. On the other hand, for older spouses about the same age, there may not be too much difference. The difference is if Betty had inherited directly she would have used a table that pretended there was the “Ten Year Younger Romeo” (slower distributions to account for the younger Romeo’s added life expectancy) but the trust is stuck with using a single person’s table (faster).
In this case, the IRA would have been required to distribute $5,847 to the trust the year after Alfred’s death
(when he would have been 82 with a factor of 17.1), the following year a factor of 16.1 would be applied to the IRA balance as of the previous December 31, the next year 15.1, and so on.
Bottom line: If a trust fails the “designated beneficiary” rule it means the IRA must be distributed within five years if the owner died before age 70 ½ and over the owner’s life expectancy (pretending he is alive and single) if he dies after age 70 ½.
Should Everything Be Distributed To Betty?
To summarize (this stuff is hard!):
If we set up a trust to qualify as a “designated beneficiary” we must decide whether to make the trustee pay out to Betty all of the distributions the IRS says the trust MUST take from the IRA (this is called a “conduit trust”), or to let those IRA distributions accumulate inside the trust (where they are protected).
If the trust is a conduit trust, Betty gets all IRA distributions and she pays all income taxes (probably at her low tax rate). Also, if a trust is a conduit trust the IRA distributions can be stretched out a little bit more than if the trust was an accumulation trust. It also means that if Betty goes to the nursing home on Medicaid, all of those IRA distributions will be paid to the nursing home before Medicaid kicks in.
If the trust gives the trustee the right to accumulate IRA distributions and to decide whether to pay some, all, or none of the IRA distributions through to Betty, the IRA will be distributed to the trust slightly faster, but the assets will be safe from nursing home expenses. To the extent the trustee decides not to distribute to Betty (maybe she is in a nursing home on Medicaid) the IRA distributions being held in the trust will be subject to income taxation at much higher rates than Betty would have paid had the trustee passed the IRA distributions on to Betty. On the other had, if they were paid out to Betty, everything might shortly be gone!
This is a complex topic. The purpose of this article was to give an overview of the possible advantages of naming a trust as IRA beneficiary. Sometimes it is a great idea, and other times it may be a really bad idea. Bring it up with your attorney or financial advisor and see what she says.